Hurdling Risks

Botched or canceled IT projects cost companies enormous amounts of money. Applying some basic principles of finance to your IT investments will help you better manage these risky ventures

AS ANY INVESTOR KNOWS, stocks are riskier investments than bonds. Investors thus require a higher rate of return for investing in stocks. In fact, most investors are risk averse--for a small increase in risk, they need a large increase in expected return.

The additional amount added to a return to compensate investors for risk is referred to as a risk premium. Just as stock investors expect higher returns to compensate for taking on higher levels of risk, executives should factor in the potential for risk as well as for return when deciding whether to fund an IT project. Yet most companies do not apply these basic finance principles to IT investments, especially to internally developed software projects, which are inherently some of the riskiest investments they make.

Hurdle Rates

A hurdle rate is the minimum ROI a company requires for investments. If the projected ROI on a proposed project is greater than the hurdle rate, the project is considered a desirable use of funds. If the projected ROI is less than the hurdle rate, the project will be given lower priority. Hurdle rates are set somewhat arbitrarily, but those who set rates usually try to take risk into account. This is why hurdle rates for IT investments are usually higher than the cost of capital.

Not all companies use hurdle rates, of course, and some industries use them more than others. "Manufacturing firms tend to have more of a hurdle-rate mentality. Service firms have less of one," says Ron Shevlin, senior analyst in the leadership strategies service of Forrester Research Inc. in Cambridge, Mass. He also notes that hurdle rates are inappropriate for most infrastructure investments because some are not optional; therefore ROI doesn't apply (and a hurdle rate is thus not a decision criterion). Additionally, some analysts argue that because an ROI calculation does not always include the intangible benefits of some projects, strict adherence to a hurdle rate would discriminate against such projects.

But many companies do use hurdle rates as a guideline for some or even all of their IT investments. The fact is that many IT investments are optional and are proposed primarily to reap some economic benefit. In such cases a hurdle rate is a completely valid decision criterion.

The problem is that most companies do not adjust the hurdle rate for risk nearly enough. Estimates of average hurdle rates vary widely. "The typical hurdle rate for IT investments is in the range of 15 percent to 18 percent for the North American firms we talked to," says Bruce Stewart, vice president in the management strategies and directions service of GartnerGroup Inc. in Stamford, Conn. Thomas D. Oleson, research director at Framingham, Mass.-based International Data Corp. (which is owned by the same parent company as CIO Communications Inc.), provides a higher range: "The [U.S.] hurdle rates I looked at were more in the 30 percent to 50 percent range, depending on the nature of the application." Oleson attributes the higher numbers to a possible difference in IDC's clients. DHS & Associates' research, on the other hand, uncovered few hurdle rates above 30 percent. If the risk premium is fully incorporated into the hurdle rate, we find that these hurdle rates may be far too low. IT investments are risky--there are uncertain benefits, potential cost overruns and possible cancellations. In fact, the cancellation rate of large projects exceeds the default rate of most junk bonds. Unless U.S. hurdle rates begin to reflect these risks, companies will continue to gamble their money on IT projects that, with better risk management, they might have nixed at the starting gate.

Risk and Return

One way to assess whether IT investments are worth the risk is to borrow a graphing technique from modern portfolio theory (MPT), the science of portfolio management developed in the 1950s. MPT shows, among other things, how one can derive the risk and return of a portfolio given the risk and return of the individual investments and how to optimize the investments of a portfolio for a given risk and return. I asked executives how they'd evaluate an IT investment of about $3 million and plotted how high an expected return they'd require before investing, given different probabilities of a negative return. As you can see from "Risk/Return Profiles", the CFO of this insurance company would accept a 15 percent chance of a negative return if the expected return--the probability-weighted average of all possible returns--was about 50 percent. The CIO, on the other hand, would need about a 150 percent return for a 15 percent chance of a negative return. The "just barely acceptable" points on the resulting graph delineate the investment boundary, or the risk aversion (or risk tolerance) of each executive.

Related:
1 2 3 Page 1
Page 1 of 3
Discover what your peers are reading. Sign up for our FREE email newsletters today!